Candlestick Patterns
Candlestick patterns are used in the stock market to predict price actions and directions. They are powerful tools for traders to make profitable trades in any financial market, including the stock market, options, Forex, and futures.
Candlestick patterns originated from Japan and are now widely used by Wall Street and retail traders across the US in trading the stock market. Candlestick patterns are especially useful for short-term traders who swing trade or day trade the market.
How to read candlestick patterns?
Traders find candlestick patterns visually appealing and easier to interpret compared to traditional bar charts. After learning how to analyze candlestick charts, you will see that they offer valuable information that a traditional bar chart does not.
For example, candlesticks reveal emotions surrounding a stock, and investors' emotions have a major impact on a stock's movement. This type of data can help traders give better predictions on where a stock might be headed.
The above chart shows what a candlestick pattern looks like. Candlesticks give us clues to price action and the market's mood.
The open and close prices are represented by horizontal lines and they form a box, called the body (also referred to as the "real body").
White candles form when the close price is higher than the open price and black candles form when the open price is higher than the close price. The long thin lines extending from the body are called shadows, or wicks, and represent the high and low range.
The high is marked by the top of the upper shadow while the low is marked by the bottom of the lower shadow. These are important because they show the extremes in the price for the trading period.
Understanding Candlestick
Short shadows show that prices are confined near the open and close. Long shadows show that prices traded well past the open and close. If the open or the close was the highest price during the trading period, then there will be no upper shadow. If the open or the close was the lowest price during the trading period, then there will be no lower shadow.
For example, bullish candles form when a stock opens, moves lower, tests support, and then bounces back to close at a high. Bearish candles form when a stock opens, moves higher, tests resistance, and then falls to close at a low.
The trader sets the time frame of each candle. For example, if you want to see the high, low, open, and close price over 30 minutes, the trader sets the time frame of the candlestick chart to 30 minutes. Then, every 30 minutes, a new candlestick is created and it takes 30 minutes for it to complete before another one forms.
Candlestick Chart
Below is a daily candlestick chart of Apple Inc.
White Candlesticks
When the close is higher than the open, a white hollow candlestick is formed, indicating buying pressure. Long white candlesticks mean that the close was significantly higher than the open and buyers were aggressive.
Although these are typically bullish, it also depends on the trend. After a long downtrend, a long white candlestick can indicate a potential reversal or support level. If it shows up after a long uptrend, it can indicate excessive bullishness.
It is important to note that a white body does not mean that the price went up from the previous day's close. It simply means that the close was higher than the open.
Black Candlesticks
When the close is lower than the open, a black-filled candlestick is formed, indicating selling pressure. Long black candlesticks mean that the close was significantly lower than the open and sellers were aggressive.
After a long uptrend, a long black candlestick can indicate a potential reversal or resistance level. If a long black candlestick shows up after a long downtrend, it can indicate panic.
A black body does not mean that the price went down from the previous day's close. The body color of the candlesticks only indicates where the close was compared to the open.
Long Candlesticks
Long white candlesticks indicate that the bulls controlled the trading and long black candlesticks indicate that the bears controlled the trading. Generally, the longer the candlestick body is, the more intense the buying or selling pressure is.
Short Candlesticks
Short candlesticks mean that neither the bulls nor the bears took control. They finished not far from where they started. Short candlesticks indicate little price movement.
Marubozu
Marubozu candles do not have upper or lower shadows. A White Marubozu forms when the open is low and the close is high. This indicates that buyers had control starting from the first trade.
A Black Marubozu forms when the open is high and the close is low. This indicates that the sellers had control starting from the first trade.
Spinning Top Candlestick
Spinning top candlesticks are those with a long upper shadow, a long lower shadow, and a small real body. Spinning tops signal indecision.
The small body, whether hollow or filled, shows that there is not much difference between the open and close even though the prices moved significantly higher and lower during the day. Neither the bulls nor the bears were able to take over.
If a spinning top appears after a long white candlestick or after a long rally, it shows weakness among the bulls and a possible change in the trend. If a spinning top appears after a long black candlestick or after a long decline, it shows weakness among the bears and a possible change in the trend.
Top 10 Candlestick Patterns
There are more than 100 candlesticks and candlestick patterns. This may seem daunting, but rest assured, we will focus on the best candlestick patterns and how to use them in trading.
1. Doji
A Doji candle is one of the most powerful reversal candlestick patterns. It is a single-candle pattern that occurs when the stock opens and closes right at or near the opening price, forming a horizontal line. The lengths of the shadows can vary. The longer the shadows are, the more significant the Doji becomes.
A Doji represents uncertainty, indecision, and equilibrium between supply and demand. Neither the bulls nor bears are winning. Traders should not make decisions based solely on the Doji. They should wait for the next candlestick to make an appropriate trade.
To learn how doji works, read the article How to Trade the Doji Pattern.
2. Bullish Engulfing
Bullish engulfing is one of the best candlestick patterns and occurs when the price of a stock moves past the high and low of the previous day's range.
This pattern consists of two opposite colored candles and is easy to identify. The first candle is a narrow range that closes down for the day followed by a wide range candle that "engulfs" the body of the first candle and closes near the top of the range.
To learn how to use the Bullish Engulfing pattern in detail, read How Bullish Engulfing Works.
3. Bearish Engulfing
This is the opposite of a bullish engulfing candlestick pattern. A bearish engulfing candlestick pattern comprises two candles, where the first one is a narrow bullish candle followed by a large bearish candle that "engulfs" the body of the first candle.
Read Bearish Engulfing to learn more about the Bearish Engulfing pattern.
4. Bullish Harami
The Harami pattern comprises a two-candle formation in a downtrend. In a Bullish Harami pattern, the body of the first candle is long and is the same color as the current trend. This is followed by a narrow range candle that closes up for the day. The open and close occur inside the open and close of the first candle. This pattern signals that the momentum preceding it has stopped and the trend is over.
5. Bearish Harami
The Bearish Harami pattern is the exact opposite of the Bullish Harami pattern. It occurs when two candles form in an uptrend, where the first candle is long and is the same color as the current trend. The second candle is narrow and closes down for the day. The candle opens and closes inside the open and close of the previous candle. This pattern indicates that the trend is over.
6. Hammer
The Hammer pattern consists of one candle that has a small body and a lower shadow at least two times greater than the body. It tends to appear in the shape of a hammer, hence the name "hammer." It is found at the bottom of a downtrend and signals that the bulls started to step in. The color of the body is insignificant; however, a green candle has slightly more bullish implications than a red candle. A positive day is required the next day to confirm this signal.
7. Inverted Hammer
The Inverted Hammer candlestick pattern is the reverse of the Hammer candlestick pattern. It also has a small body, where the open, close, and low are near the low of the candlestick, and the upper shadow is at least two times greater than the body. This pattern is found at the bottom of a downtrend.
Read Inverted Hammer to learn how to use the inverted hammer in stock trading.
8. Shooting Star
The Shooting Star has the same shape as the Inverted Hammer, consisting of one candle with a small body and an upper shadow at least two times greater than the body. The difference is that the shooting star is found at the top of an uptrend. This pattern looks like a shooting star falling from the sky with the tail trailing it, hence the name "shooting star."
9. Hanging Man
The Hanging Man has the same shape as the Hammer, consisting of one candle with a small body and a lower shadow at least two times greater than the body. The difference is that the hanging man is found at the top of an uptrend. This pattern looks like a head with the feet dangling down, hence the name "hanging man."
10. Dark Cloud Cover
The Dark Cloud Cover pattern consists of a two-candle formation in an uptrend. The first candle is green, a continuation of the existing trend, and is followed by a red candle. The red candle's opening is higher than the high of the previous day. It closes more than halfway down the first candle.
How To Find Candlestick Patterns?
Searching for Candlestick Patterns manually is a hard task. By the time you find these patterns, it may already be too late. Therefore, we developed Candlestick Stock Screener to help you search for candlestick patterns quickly and easily, and it will save you a lot of time.
Candlestick Pattern Books
To learn more about Japanese candlestick charting techniques, we recommend the following books.
1. Japanese Candlestick Charting Techniques
2. Profitable Candlestick Trading
Final Words
While candlestick patterns are useful in trading, one mistake that I see beginners often make. They treat candlestick patterns as a science rather than art. In science or math, one plus one always equals two, but that's not how candlestick patterns or trading work.
Candlestick patterns are just a tool that traders use to predict the market, but it doesn't mean their prediction is always going to be right.
When the pattern works and the stock is moving in your direction, then even a novice trader will do well. However, what differentiates the winning traders from the losing traders is when the pattern breaks after the stock is bought.
The winning trade will cut their losses quickly and move on to the next trade while the losing trader would usually hang on and hope the stock would reverse so that he can exit even. Hoping is not a strategy that traders should rely on. Every trader should develop a system that automatically cuts losses when the trade is not working out.
Assume you are wrong in the position until it is proven right, not the other way around. Follow this simple step in stock trading and you are well ahead of your peers.